The Government Really Screwed Up This Time. Here's How You Can Profit From the Mistake.

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The current bullish outlook for record high grain prices is primarily the result of actions by the U.S. Congress. The tax legislation enacted by Congress in December to extend the Bush tax cuts included an amendment by Senator Grassley of Iowa to continue federal subsidies for ethanol i.e. the 45 cent per gallon blenders' tax credit for gasoline companies which buy and use ethanol. The tax bill also extended the 54 cent tariff on ethanol imports from Brazil. The end result of these extensions is more demand for ethanol and no competition from Brazil.

Approximately 41% of this year's entire U.S. corn crop is being diverted to the production of fuel ethanol thanks to legislation passed by Congress. On the Global stage 50% of the Brazilian sugar cane crop is being used to produce fuel ethanol. It is no wonder the price of agricultural commodities and the price of food are headed higher.

As of 1/17/11, corn was trading for $6.4875/bushel. This price will likely have to head higher in order to convince enough farmers to switch their plantings to corn, which will be necessary to meet the current demand for it for ethanol production. The challenge, of course, is that given the record demand for soybeans from China, soybeans cannot afford to give up millions acres to corn. As corn trades higher, so will soybeans.

The experts who I have spoken with fully expect corn to trade over $7 a bushel within the next 60 days. They won't rule out seeing a real blow out in prices this spring whereby the price of corn exceeds $8. Soybean prices are expected to trade higher in tandem with corn which would add another $1 or more to soybean prices.

Corn and soybean prices likely have considerably more upside even though they are already trading at the second highest level ever.

The key dates to watch with this trade are February 23 & 24 for the USDA Outlook Conference and March 31 for the USDA acreage report. The current situation is so serious that grain and soybean prices will trade above the record high set in July 2008. Over the next 3 to 4 months we are likely to hear talk of world grain and food shortages and scarce global supplies of fertilizer.

As a result of these moves in grain prices, we are likely to see the share prices of the companies which sell farm inputs also trade higher. While many of them aren't exactly cheap at this level by any stretch of the imagination, their future earnings will be so great as a result of the demand from farmers looking to squeeze every possible ear of corn and soyboean out of their acres and from the momentum that the food shortage headlines that we very well may see in the news in the coming months that fertilizer and seed companies likely have more upside as a trade.

I'm hesitant to mention any specific names because I am seriously considering adding to a position or two that I have already established and I don't want to lock myself out. One name that I will throw out there because I don't currently own it (I like one or two other companies in the sector better) is Potash (POT). POT is well below its 2008 high of $235 a share and we could see that stock trade up another $70.

One has to be careful because the stock of many of these companies have already run up considerably and we may see some corrections in the extremely short term. However, as long as corn trades higher...and it certainly looks as though it will, these stocks probably don't have much downside. The corn market almost always prices in the potential for a shortage in advance. Based on feedback from people in the industry who I have spoken with, I suspect that corn will trade higher through the third week of June just prior to the June 30th acreage report.

The flipside of this trade is that companies that use food as inputs, like restaurants, or sell food, like grocery stores, will likely see their stocks come under pressure in the coming months as their costs rise in tandem with grain prices and their earnings suffer.

There has been a number of great posts and articles written lately about whether supermarkets, such as WINN and SVU, represent an attractive investment opportunity.

I've picked up a couple of the cheap grocers here in CAPS, but I just haven't been able to bring myself to buy stock in any in real life. I think that the biggest problem that I have with these companies, is not their massive debt levels, low barriers to entry, destroyed brands, or low margins like many people cite as being an issue. The thing that is preventing me from putting real money to work here is the massive food inflation that I see coming down the pipeline.

As I mentioned, I fully expect corn to trade higher in the near future. One could say, "So what this is just corn?", but the impact that this one commodity has will be wide-reaching. As acres are shifted away from other commodities like oats, soybeans, etc and towards corn the prices of those commodities will surge as well. All of these things are used as feed for livestock so meat prices are going to continue to head higher.

All this will lead to leap in food prices, significantly above and beyond the increases that we have seen already. This is bad news for grocery stores, particularly lower-end ones who with their razor thin margins in a competitive marketplace will have a hard time passing these cost increases along to consumers. Add to this the fact that consumers will likely be strapped for cash by the high food prices and $3+/gallon gas and discretionary purchases at grocery stores will likely decline.

Here's a recent quote that SuperValue's CEO made on the company's quarterly conference call that sums up the current retail environment for grocers fairly well:

"This is going to be a challenging year going forward to manage inflation," Supervalu CEO Craig Herkert told analysts Tuesday. "It's just a fact and we believe these inflationary measures are going to impact consumers."

Great stress in companies often leads to great investment opportunities. Heaven knows that my risk-averse nature when it comes to investing has caused me to miss out on a number of home run investments like the grocery stores may ultimately be. If this was just a one-time event, like the Gulf of Mexico disaster, an earnings miss, etc... I could see this as an excellent opportunity to sneak some cheap stocks in the sector. However, I just don't see this food price inflation as a temporary phenomenon, unless the government realizes the error of its ways and how its ethanol mandates are the cause of the run-up in ag commodity prices.

There's an interesting article out there by the AP on this subject today that's worth a read:

If you are correct and there is significant and enduring food price inflation heading our way, I wonder if this could end up being a catalyst for the onset of overall inflation? This would suggest one buy not only ag-related companies (DE, MON, LNN, POT, AGCO, CRESY) but also commodities.

Thanks Rich. Nahhhh, there's no inflation here. Forget about those high prices that you're paying at the gas station and grocery store every week and remember that it's only CORE inflation that counts ;).

Food carries about a 15% weight in CPI calculation, so a food rise of ~3% as projected by the USDA (per the yahoo link) will contribute about half a point to overall inflation. Add to that the rise that has apparently not yet been passed on to consumers and the potential for food prices to rise significantly more than the USDA projects, and it's easy to see how food prices alone might add multiple percentage points to inflation in the coming year.

I have a couple of friends that farm mostly raising livestock. One raises a lot of hogs and has been crushed by the increased feed costs. The other has commented that input costs have risen so much that a mistake or bad crop year can be very damaging. At what point will ethanol become a major political issue? Is this a way for the US to leverage for cheaper oil? Will there be pressure from the world to provide lower cost oil to the US so we stop using corn for fuel?

According to the USDA, despite the rising price of corn, US production is expected to decrease almost 5% as compared to last year.

Also according to the USDA, 300 million, of 400 million acres of US cropland are currently beiing harvested.

According to 'Amber Waves';

Field corn is the predominant corn type grown in the U.S., and it is primarily used for animal feed.

Currently, (2008) less than 10 percent of the U.S. field corn crop is used for direct domestic human consumption in corn-based foods such as corn meal, corn starch, and corn flakes, while the remainder is used for animal feed, exports, ethanol production, seed, and industrial uses.

Sweet corn, both white and yellow, is usually consumed as immature whole-kernel corn by humans and also as an ingredient in other corn-based foods, but makes up only about 1 percent of total U.S. corn production.

Currently,about 4.1 percent of U.S.-produced corn is made into high-fructose corn syrup. A 2-liter bottle of soda contains about 15 ounces of corn in the form of high-fructose corn syrup valued at 3.8 cents when corn is priced at $2.28 per bushel. - (.11 cents at todays $6.60/bushel price)

An 18-ounce box of corn flakes contains about 12.9 ounces of milled field corn. When field corn is priced at $2.28 per bushel (the 20-year average), the actual value of corn represented in the box of corn flakes is about 3.3 cents. (9.5 cents at todays $6.60/bushel price)

Currently,(again 2008) about 55 percent of corn produced in the U.S. is used as animal feed for livestock and poultry

To avoid downplaying potential impacts, this analysis uses upper-bound conversion estimates of 7 pounds of corn to produce 1 pound of beef, 6.5 pounds of corn to produce 1 pound of pork, and 2.6 pounds of corn to produce 1 pound of chicken.

At todays price of $6.60/bushel that is .23 cents for one lb of chicken.

Currently (today) US corn ethanol production is at 12.5 billion gallons/year and should rise to 15 billion by 2015 at which time corn ethanol growth will stop and cellulosic ethanol will growth will increase.

Todays US average price for ethanol is $2.52/gallon, add in the $.45 subsidy and it is $2.97.